Several commodity exchanges, such as the International Petroleum Exchange, the New York Mercantile Exchange, the Tokyo Commodity Exchange, and the Singapore Exchange have over the years launched, or attempted to launch, futures contracts referencing one or more of the world's commonly traded crude oil grades. These grades are referred to by the petroleum industry and financial community as crude oil benchmarks or markers, and include Brent, Dubai, Oman, Tapis, Urals and West Texas Intermediate (WTI). In order for a crude type to be considered a true international marker, the grade must be capable of being transported from the oil field where it is produced, to refining centers around the world. The most common method of transporting crude from export terminals to oil refineries, is via large ocean-going vessels. (Presently, however, WTI is precluded from being a true international marker crude due to export restrictions imposed by the United States government.)
Presently, all commodity exchanges with petroleum futures contracts referencing one or more international crude markers are cash settlement contracts. Under the terms of these contracts, all open long or short futures positions at contract expiry are financially settled against an index. Due largely to load-port terminal and vessel shipping constraints, commodity exchanges that have developed international marker crude oil contracts have chosen to use financial settlement to meet obligations resulting from open positions held through expiry of the contract. Under this previous method, the futures exchange calculates an index price on the final day of trading. All outstanding open futures positions held beyond contract expiry, are financially liquidated, or cash-settled against the index price. No physical delivery of the commodity takes place.
In the past, some crude oil futures exchanges with cash settlement contracts have purported their contracts are in fact physical delivery. These claims relate solely to exchange for physical (EFP) provisions within the contract, and are misleading and are fallacious. An EFP simply involves physical delivery from one participant to another with a concomitant assumption of equal, but opposite futures position by participants. EFP trades are strictly voluntarily. The EFP transaction is simply an optional trading tool, that market participants can choose to use to shift physical positions “on” or “off” a futures exchange, thus optionally allowing participants to convert physical delivery into futures positions and vice versa. The futures exchange does not mandate these trades, nor does it match the market participants in an EFP transaction. Additionally, the market participant in an EFP transaction assumes the performance and financial risk of the counterparty, with respect to the physical portion of the EFP. In an EFP transaction market participants lose the financial protection provided by the futures exchange. Consequently, futures exchanges cannot assure market participants physical delivery under their cash settlement contracts, and claims to the contrary are incorrect. As such, a need exists, for a futures contract that guarantees physical delivery.
The major unsolved problem futures exchanges have faced in the past when trying to structure a physical delivery contract for commodities that load in bulk, is developing a product that trades in lots large enough to meet the minimum requirements of producers, consumers, and hedgers, commonly referred to as “commercials,” and small enough to appeal to a wide range of investors, speculators, and exchange floor locals, commonly referred to as “non-commercials.” A physical delivery contract ideally should satisfy the needs of both commercials and non-commercials.
In addition to not providing physical delivery of the commodity, cash-settlement futures contracts for commodities that load on large ocean-going vessels present other difficulties for market participants attempting to manage risk. These risks include exposure to pricing distortions resulting from large highly leveraged futures positions held by one or more market participant and pricing basis risk (i.e., the risk associated with the difference between the futures exchange closing price on expiry and the final published index price).
Exposure to pricing distortions occurs, at least in part, because exchanges with cash-settlement futures contracts have not imposed position limits on individual market participants. All futures positions held through expiry are liquidated by the exchange, and financially settled at the index price. This contract feature enables market participants to accumulate and retain large futures positions, through expiry, as leverage for large physical positions in the underlying commodity. This may distort prices and prevent convergence of the futures and physical price of the commodity upon contract expiry.
Basis risk occurs because, the final index price, against which all open positions are financially settled, is typically not released by the futures exchange until well after the close of trading. Some exchanges do not publish the index price until the following business day because details of the physical transactions and market assessments used in the calculation of the index are often delayed, as price reporting services gather, verify and publish price information.
To avoid pricing basis risk against the index, market participants with open futures positions on the final trading day must ratably replicate all the physical trades during the index period. This is infeasible as the index assessment period can be as long as twenty-three (23) hours, and information on the concluded physical trades that generate the index is not available to the market participant in real-time.
Furthermore, minimum loading volume for delivery under a single contract in the forward physical market for commodities that load on large, ocean-going vessels is a significant multiple of the size of a single futures contract in the same commodity. For example, the difference is approximately 600,000 barrels for the physical forward contract verses 1,000 barrels for the futures contract. In liquid natural gas (LNG), the difference is approximately 138,000 CBM verses 10,000 MMBtu for the futures contract. The large size of a single physical contract makes it difficult to liquidate positions ratably during the index period and, therefore, to avoid basis risk.
Thus, a need exists for an improved futures contract and, more specifically, a futures contract guaranteeing physical delivery of the underlying commodity that reduces exposure to pricing distortions and basis risk.